Article / 15 June 2016 at 11:00 GMT

Weekly Bond Update: Bubble gumming up the works?

Fixed Income trader / Saxo Bank
  • Financial crises almost always come down to bursting bubbles
  • Major investors calling for bond market 'supernova'
  • Low rates, yields affect valuations across asset classes, markets

Ready to blow?
Are bond markets ready to blow, or is this just another case 
of forecasters singing the blues? Photo: iStock 

By Michael Boye

Throughout financial history there have been many financial crises and panics, almost all of which have been caused by the rapid deflation of asset bubbles, with the financial crisis stemming from the US housing bubble being the most recent and dramatic example. 

These bubbles are often characterised by a herd mentality among investors driving asset prices ever higher, and as the process wears on it tends to convince even the most reluctant bystanders of its continued sustainability. 

In fact, the forces of conviction are often so strong that you will be considered a laughingstock for taking the opposite view (as Peter Schiff famously was back in 2006). For this reason, you'll often hear the counter-argument that if too many people are talking about it, it can't be a real bubble.

This argument could soon be relevant for bond markets, which have been the subject of a growing bubble discussion lately. This only gained further traction this week, when the 10-year German government yield went into negative territory for the first time on record. 

Allianz, the German insurance company, is the latest prominent member of the bond bubble chorus, joining the likes of Bill Gross who earlier this year said bunds were the “short of a lifetime” and added last week that bond markets are “a supernova that will explode one day”

With government yields across the developed world on the decline for decades (brought about by multi-year prolonged easy monetary policies from major central banks) and now also the difficult-to-fathom concept of governments actually being paid to borrow for as much as 10 years or longer, it does seem a straightforward conclusion. 

10-year German government yield since 1800:

Source: Deutsche Bank

However, this time the discussion isn't centered about any of the usual asset classes, nor real estate or flowers or anything else of that sort. Now, the issue lies at the very core of financial markets. Indeed, government yields are the heart of the financing rates behind every major asset or loan, and thus directly impact every lending or mortgage rate as well as every asset valuation that a business or individual in the developed world would see. 

Furthermore, given the direct involvement and participation of all the major central banks in the Western world, who have all aparently joined forces to ensure this low-yield environment, its continuation is highly dependent on the effectiveness of these very policies as well as the confidence that financial markets place in the ability of central banks to keep liquidity flowing. 

In fact, maintaining the presence of a bubble in government bond markets would actually imply a bubble in central bank confidence or paper money itself, which, if it were to unfold, would have much more comprehensive consequences for financial markets. 

Imagine what stressed interest rate levels would do to equity valuations, real estate prices and business everywhere, which arguably have been all but propped up by easy liquidity conditions ever since the great financial crisis.

Given that more and more people are talking of a bubble, we had better hope that this is yet again a strong indication that it isn't in fact a bubble about to burst... but history teaches us to be cautious on this point. 

After all, he who calls the latest doomsayer a laughingstock right before the doom actually comes to pass, quickly becomes a laughingstock himself.

The end is near
These sorts of forecasters are usually proven wrong... usually, but not always. Photo: iStock 

— Edited by Michael McKenna

Michael Boye is a fixed income trader at Saxo Bank

How would you recommend to react (investment wise) if this type of scenario would occur?


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